The Japanese Yen and carry trades

The Japanese economy continues to strengthen, as the end of its zero interest rate policy drifts closer. However, economists are still looking for tightening in the third quarter, as the level of market uncertainty potentially increases and monetary policy communication becomes more challenging.

The Bank of Japan's new policy framework primarily has three aspects: first, the understanding of the policy board about price stability, which provides a longer-term anchor for price expectations, second a forward-looking risk assessment, which is an improvement over the "backward-looking" reference to the core CPI under the quantitative easing policy, and finally an assessment of policy implementation. The new framework is an attempt to be transparent, flexible and forward-looking.

At this stage the Bank of Japan (BOJ) does not appear to have a clear idea of how policy will progress from here, what factors will influence its decisions, and, perhaps most importantly, how it will communicate its decision-making process. In particular, the role to be played by market expectations and how this will feed back into the market is unclear. This raises the risk of potential market instability if the market misunderstands the BOJ.

HSBC Research retains a bullish sentiment on the Japanese yen. The uncertainties may mean that the Japanese currency struggles to rally until some further clarity on the policy front. The negative carry on a short US dollar-Japanese yen exchange rate position is still significant. Beyond questions about the timing and conduct of policy, the impending end of the zero interest rate policy (ZIRP) has brought the yen carry trade to be a significant focus for central banks, international monitoring agencies and the market. Myths here, unfortunately, abound.

To clarify matters, it must be noted that, on one level, the yen carry trade is a portfolio investment decision by Japanese households. This is evidenced by the flow of money out of Japan into, largely, foreign fixed income assets. On another level it refers to a global investors' decision to sell Japanese yen as a foreign exchange transaction (effectively borrowing at the Japanese overnight rate) and then undertaking a subsequent series of transactions to firstly buy another currency, and then potentially an asset denominated in that currency.

The first type of carry trade can, in fact, be measured. The Japanese balance of payments numbers provides a consistent data set. The second type of carry trade cannot be measured. The latter type is also almost certain to be more active, more speculative, and more inclined to take profit. This is the carry trade which caused problems in 1998, and is where the focus should be now.

It is difficult to know how large the Foreign Exchange-type of yen carry trade might be. Certainly interest rate differentials this time between Japan and the US have been sustained at wide levels for a much shorter period. This suggests that the US dollar has been a less significant beneficiary this time around. On the other hand, all this may indicate that low Japanese interest rates have been used to fund into assets apart from those in the US.

As a signal that the end of ZIRP is close, the reduction in current account balances may have been significant. It is doubtful, however, that a rise in short-term interest rates, when it comes, will be all that significant for the carry trade, at least in isolation.

Certainly, the expected tightening is likely to be very modest for at least the remainder of this year. HSBC Research expects the call rate to rise to 25 basis points by the end of the year. However, it is difficult to see such a modest rise in the call rate affecting yen funding in any material way.

By definition, for an investor to take advantage of cheap yen funding to buy offshore assets, they need to run an unhedged short yen position. The only sense in which Japanese money has been free is if one borrowed in yen to also buy a yen denominated asset. Using either historic or current implied volatility, the yen is one of the most volatile currencies in Asia. Such a move poses a much bigger risk to the 'yen carry trade' than do very small moves in Japanese interest rates.

1998 is a good example. In the lead-up to the 1998 collapse in USD-JPY exchange rate there was some modest narrowing in two-year bond differentials between Japan and the US. Cash rate differentials, however, had not shifted for the better part of two years.

While there was clearly a large position adjustment associated with the unwinding of the yen carry trade, this adjustment was not sparked by a move in Japanese interest rates. The lesson is relatively clear: watch the yen and not the BOJ when worrying about the risk to positions funded using low Japanese interest rates. The point is that a strong yen begets an even stronger yen as the carry trade unwinds and this is a foreign exchange phenomenon, not necessarily an interest rate one.

This report was compiled by Peter Calleya, manager, Corporate Strategy & Research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.